As we've seen, the U.S. government—“Uncle Sam”—spends money on goods and services, thus boosting GDP. The government also makes transfer payments, which are not counted in the government's contribution to GDP. Transfer payments can, however, contribute to consumption expenditure if they wind up in the hands of households who will spend that money, which they often do. But that's part of “C,” and we are now discussing “G.”

The government's money comes from only two sources: taxes and borrowing. The government levies taxes on and borrows funds from the private sector. This is true of government at the federal, state, and local levels. (Yes, government agencies do charge fees, for instance at national and state parks, and states and cities assess fines for criminal and traffic violations. Technically, these are not taxes, but economists lump them in with tax revenue.)

The role of the government in an economy is large and complex, and there are various views of how the government should play it. In most modern, capitalist economies, however, the role of the government is to create and maintain conditions that will ensure a stable, orderly (but free) society.

EconoTalk

Inflation refers to price increases that erode the value of currency.

The most basic of these conditions are a sound currency, low unemployment, and sustained economic growth. A sound currency maintains its buying power, because the economy undergoes minimal inflation. We'll talk about inflation in The Economist's Toolbox.

The government uses economic policy to help ensure a sound currency, low unemployment, and sustained growth. Economic policy falls into two broad areas: fiscal policy and monetary policy. Fiscal policy has to do with budgetary matters, such as taxes, spending, and borrowing. Monetary policy, , has to do with interest rates and the amount of money in the economy.

In their effect on economic growth, the government's policies are as important as its actual purchases of goods and services. Those policies determine not only government spending, but also taxes or borrowing; and spending, taxes, and borrowing all profoundly affect the economy.